The interest rate channel of monetary policy refers to the way in which RBI’s repo rate change influences inflation and other monetary policy targets.
If the RBI signals a decline in interest rate through a repo rate cut, commercial banks respond with interest rate reduction on both deposits and loans.
An interest rate cut by banks inevitably increases loan demand by households and business people. Households take loans to make consumption expenditure. Business firms or corporate take loans generally to finance their investment activities. Increased loan off-take raises consumption demand. As a result, production, investment, employment and income of the people go up powered by the incentives of low interest rate policy. All these happen in a related and sequential manner. So, an interest rate cut signal by the RBI, by raising consumption and investment, increases income, employment and economic growth. This how the interest rate channel of monetary policy works. Similarly, the opposite effect may be produced when the RBI increases repo rate to fight inflation.
